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VIDEO: Art Laffer on the Laffer Curve - GRADE 9-12

A short video featuring none other than Art Laffer explaining his eponymous curve. The Laffer Curve recognizes that tax rates may become so high that they actually reduce the total revenue collected - or in the words of political commentator John Maynard Keynes, 'taxation may be so high as to defeat its object.'



Note that the illustration of the Laffer Curve in the video is depicted with the tax rate on the vertical axis and the tax revenues collected on the horizontal axis, whereas normally these variables are depicted on the opposite axes as above. This was done so that Art can make the joke at the beginning of his video.


The 'Arithmetic Effect' refers to the increase in tax revenue that results from applying a higher tax rate to a given tax base (tax base = the total number of individuals subject to the tax). This is what most people understand when they think about the relationship between tax rates and tax revenue. While the 'Economic Effect' refers to the decrease in tax revenue that results from individuals voluntarily leaving the tax base as a result of the higher taxes (e.g. for an income tax this would refer to individuals deciding to retire early, take on less overtime, shorten shift length, or otherwise work less as a result of the higher tax rates).


Note to Calculus Teachers: the "Arithmetic Effect" and the "Economic Effect" that Art refers to are the Left and Right-hand side of the Product Rule, respectively - namely 1xQ(T)+TxQ'(T), which is what you get when you differentiate the formula for tax revenues TxQ(T) with respect to T, where T is the tax rate and Q is the number of workers in the tax base. Note that 1xQ(T)>0 and Q'(T)<0, so lower tax rates will have the salutary effect of increasing tax revenues when the Arithmetic Effect is being overridden by the Economic Effect, giving us this somewhat counterintuitive result of the Laffer Curve.


Historic Examples:

1. Between 1921-29 US income tax rates across all brackets were greatly reduced - for the top bracket income tax rates were reduced from 73% to 25%. Consistent with the Laffer Curve and excessively high tax rates, over the same period the share of the federal income tax paid by earners in the top bracket nearly doubled from 44.2% in 1921, to 51.8% in 1922, 69% in 1925, and 78.4% in 1928.


2. In 1963, President John F. Kennedy proposed The Tax Reduction Act which reduced personal income tax rates by approximately 20% across all tax brackets, including the top marginal income tax rate from 91% to ‘only’ 70%. The proposed bill was passed into law by the U.S. congress in early 1964. Consistent with the Laffer Curve and excessively high tax rates, federal income tax revenues increased in 1964.


3. In 1986, under President Ronald Reagan, the U.S. congress lowered the top federal income tax rate from 70% to 28%. Consistent with the Laffer Curve and excessively high tax rates, federal income tax revenues increased by 11.0% in 1987, compared to only a 4.8% increase the previous year.


4. Between 1991 and 2001 Iceland reduced its corporate income tax rate from 45% to 18%. Over this period its economy grew by just 19%, but consistent with the Laffer Curve and an excessively high tax rate, the revenues collected from this tax tripled.


5. In 1997, President Bill Clinton led a reduction of the tax rate on capital gains from 28% to 20%. Consistent with the Laffer Curve and an excessively high tax rate, the tax revenues collected doubled.


6. In 2008, Maryland increased its top income tax bracket by 6.25%. Consistent with the Laffer Curve and an excessively high tax rate, the tax revenues collected declined by $257 million.


7. In 2009, Oregon raised its state income tax rates by adding two additional and higher tax brackets collecting 10.8% and 11% of earned income. Consistent with the Laffer Curve and excessively high tax rates, state income tax revenues declined by $50 billion.


8. In 2022 Norway increased the country's wealth tax from 0.85% to 1.1%. The government projected that this would increase annual wealth tax revenue of $1.46bn by some $150m (according to the pure Arithmetic Effect of the tax but ignoring the Economic Effect). However, because many of Norway's wealthy individuals decided to relocate to a foreign country in response (the Economic Effect), the government in fact lost $594m in tax revenue due to this new policy - which is consistent with the tax policy being on the right-hand (irrational) side of the Laffer Curve.


Of course, as the left-hand side of the Laffer Curve also depicts, tax revenues don't always increase when tax rates are reduced as in the above examples - this only happens when the tax rates have been 'irrationally' excessive. What is a tax rate that is 'excessive' (i.e. on the right-hand side of the Laffer Curve)? This depends on the particular type of tax (e.g. sales, income, corporation) and other relevant circumstances that determine how much workers will exit the labor force in response. With regard to an income tax, historically tax revenues often start to decline when combined state and federal rates are greater than 50% - which makes sense - many people would rather sit on the beach if they won't even receive half of what they earn.


Note also that, whatever this threshold tax rate may be, this rate should not be considered as an optimal target tax rate - this is only the tax rate beyond which policy has become irrational. Tax rates lower than this threshold, though they will collect less revenue, do benefit the broader society because they will result in lower market prices for consumers, higher consumer surplus for producers, and lower deadweight losses for society.


References

BEA, Bureau of Economic Analysis (2020) “GDP and Personal Income” and “Federal Government Current Receipts and Expenditures” Tables 3.2–3.5 (May 28). Interactive data available at https://​apps​.bea​.gov/​i​t​a​b​l​e​/​i​n​d​e​x.cfm.


Frenze, C. (1982) “The Mellon and Kennedy Tax Cuts: A Review and Analysis.” Joint Economic Committee Staff Study (June 18).



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